6 Case 11 Chicago Valve Company Capital Budgeting Directed Although he was hired as a financial analyst after completing his MBA, Richard Houston’s first assignment at Chicago Valve was with the firm’s marketing department. Historically, the major focus of Chicago Valve’s sales effort was on demonstrating the reliability and technological superiority of the firm’s product line. However, many of Chicago Valve’s traditional customers have embarked on cost-cutting programs in recent years. As a result, Chicago Valve’s marketing director asked Houston’s boss, the financial VP, to lend Houston to marketing to help them develop some analytical procedures that the sales force can use to demonstrate the financial benefits of buying Chicago Valve’s products. Chicago Valve manufactures valve systems that are used in a wide variety of applications, including sewage treatment systems, petroleum refining, and pipeline transmission. The complete systems include sophisticated pumps, sensors, valves, and control units that continuously monitor the flow rate and the pressure along a line and automatically adjust the pump to meet pre-set pressure specifications. Most of Chicago Valve’s systems are made up of standard components, and most complete systems are priced from $100 000 to $250 000. Because of the somewhat technical nature of the products, the majority of Chicago Valve’s sales people have a background in engineering. As he began to think about his assignment, Houston quickly came to the conclusion that the best way to “sell” a system to a cost-conscious customer would be to conduct a capital budgeting analysis which would demonstrate the cost effectiveness of the system. Further, Houston concluded that the best way to begin was with an analysis for one of Chicago Valve’s actual customers. From discussions with the firm’s sales people, Houston concluded that a proposed sale to Lone Star Petroleum, Inc. was perfect to use as an illustration. Lone Star is considering the purchase of one of Chicago Valve’s standard petroleum valve systems, which costs $200,000, including taxes and delivery. It would cost Lone Star another $12,500 to install the equipment, and this expense would be added to the invoice price of the equipment to determine the depreciable basis of the system. A MACRS class-life of five years would be used, but the system has an economic life of eight years, and it will be used for that period. After eight years, the system will probably be obsolete, so it will have a zero salvage value at that time. Current depreciation allowances for 5-year class property are 0.20, 0.32, 0.19, 0.12, 0.11, and 0.06 in Years 1-6, respectively. This system would replace a valve system which has been used for about twenty years and which has been fully depreciated. The costs for removing the current system are about equal to its scrap value, so its current net market value is zero. The advantages of the new system are greater reliability and lower human monitoring and maintenance requirements. In total, the new system would save Lone Star $60,000 annually in pre-tax operating costs. For capital budgeting, Lone Star uses an 1 1 percent cost of capital, and its federal-plus-state tax rate is 40 percent. 0 1994 South-Western, a part of Cengage Learning 49Natasha Spurrier, Chicago Valve’s marketing manager, gave Houston a free hand in structuring the analysis, but with one exceptionshe told Houston to be sure to include the modified IRR (MIRR) as one of the decision criteria. To calculate MIRR, all of the cash are compounded to the terminal year, in this case Year 8, at the project’s cost of capital, these values summed to produce the project’s terminal value. compounded are Then, is found as the discount rate which causes the present value of the terminal value to equal cost of the equipment. Spurrier had recently attended a seminar on capital budgeting according to the seminar leader, the MIRR method has significant advantages over t…
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